|
IMF’s
latest assessment on Lankan macro economic progress
IMF
Executive Board Concludes 2007 Article IV Consultation with Sri
Lanka
On
November 21, 2007, the Executive Board of the International Monetary
Fund (IMF) concluded the Article IV consultation with Sri Lanka.
Background
Sri Lanka’s strong economic growth in the past four years has
lifted per capita income to about $1,300, well exceeding regional
peers. Reflecting the economy’s resilience, in 2006, real growth
accelerated to 7½ percent despite the oil price shock and
heightened security conditions.
There are, however, indications that the economy may be operating
at full capacity given rising inflation, a low unemployment rate,
and a high current account deficit. High oil prices, slow fiscal
consolidation, and security concerns are key risks to the near term
growth-inflation outlook.
Monetary policy tightening in 2006 was insufficient to contain inflation,
but additional measures were taken in early 2007. In January 2007,
the Central Bank of Sri Lanka (CBSL) announced its “Road Map”
aiming at reducing inflation to single digit levels by the end of
the year through a tighter monetary stance. To this end, the CBSL
limited banks’ access to the reverse repo window and strengthened
prudential measures to contain excessive exposure to sectoral risks.
Also, the CBSL stepped up open market operations and allowed treasury
rates to increase to 17½ percent during January-June (from
12½ percent at end-2006).
These
measures, together with a dissipation of pass-through effects from
administered price adjustments, contributed to a deceleration in
inflation to (annualized) single digits in the first four months
of 2007, and real interest rates started to turn positive. This
favorable inflation trend has, however, reversed since May and inflation
increased to 21¾ percent (yoy) in August due to the combined
effect of the elimination of remaining fuel subsidies, increases
in food prices, and a pause in further monetary tightening during
that period.
The fiscal deficit target for 2007, at 7.8 percent of GDP, indicates
a modest fiscal consolidation from a deficit of 8.4 percent of GDP
in 2006.
This
target envisages a substantial increase in tax revenue, a full elimination
of fuel subsidies, and a containment of the wage bill. Together,
they are expected to more than offset increases in military expenditure,
spending on goods and services, and capital spending. Revenue grew
by 25 percent in the first half of 2007, but it was still at about
40 percent of the ambitious annual target. Wages and military spending
have been contained as of June, but they could continue to be key
fiscal risks in the period ahead. The 2008 budget proposal targets
a marginal reduction in the fiscal deficit to 7.7 percent of GDP.
This falls considerably short of the authorities’ earlier plans
to lower the deficit to 6.3 percent of GDP in 2008 (under the 2008
Budget Call announced in July).
The external current account deficit is projected to sustain at
around 5 percent of GDP in 2007 while reserves are expected to remain
at around 2½ months of imports. In the first half of 2007,
exports and remittances continued to grow strongly, while import
growth decelerated mainly owing to limited increases in world oil
prices during that period. For the year as a whole, healthy exports
and remittances are expected to be largely offset by the implementation
of mega infrastructure projects and high oil prices since July.
In light of favorable local and global liquidity conditions in the
last two years, the government has continued to resort to dollar-denominated
borrowing to finance the budget while supporting reserves. By end-2006,
the public domestic dollar commercial debt reached $1.6 billion
(or 6 percent of GDP) at an average maturity of 1½ years.
Over 90 percent of this debt was financed from domestic sources,
including remittances. This has resulted in a bunching of foreign
exchange debt service over the next few years, but so far favorable
market conditions have allowed the government to refinance this
debt at low cost. In October the government successfully issued
its first $500 million international sovereign bond at a yield of
8¼ percent and maturity of 5 years.
Significant progress has been made in improving financial sector
stability. Salient features include a sharp decline in the NPL ratios
across banks, a marked strengthening in the capital base of the
banking industry, and a sustained improvement in banks’ operating
profits.
Moreover, implementation of the Basel Core Principles has advanced
to facilitate a planned adoption of Basel II in 2008. Nevertheless,
underlying structural and operational weaknesses remain. Further
efforts should focus on improving banking sector resilience to shocks
through improving asset quality and strengthening credit and liquidity
risk management; strengthening risk-based supervision; and advancing
structural and operational restructuring in public banks and limiting
state interference.
Financial viability of the energy sector is central to fiscal consolidation
and debt sustainability over the medium term. Ceylon Electricity
Board (CEB) is likely to incur financial losses of about 20 billion
rupees (¾ percent of GDP) in 2007, due primarily to the lack
of adjustment in electricity tariffs, which have fallen well below
cost recovery levels. A large part of these losses was financed
by loans from public banks, posing risks to the financial sector.
The authorities’ medium-term strategy is to use alternative
and cheaper energy sources to reduce Sri Lanka’s heavy reliance
on oil-based thermal power generation.
The
construction of three coal power plants (total 900 MW) is expected
to be completed during 2008-10. This will not only address the acute
energy shortage in Sri Lanka but also significantly lower the cost
of energy production (by about one-third from the current level)
and bring the CEB to cost recovery levels.
Executive Board Assessment
Executive Directors welcomed Sri Lanka’s impressive recent
growth performance, which has led to a sharp reduction in unemployment
and rising per capita income. At the same time, Directors noted
that growth has been underpinned in part by expansionary fiscal
and monetary policies, leading to an increase in macroeconomic and
external sector vulnerabilities. In particular, inflation has accelerated,
the external current account deficit remains large, and gross official
reserves are relatively low. Directors urged the authorities to
tighten macroeconomic policies, while acknowledging that a return
to political stability will also be crucial in underpinning sustained
economic progress going forward.
Against this background, Directors called for a determined effort
to reduce the fiscal deficit to 5 percent of GDP by 2010-11 as planned.
This will be essential to ensure public debt sustainability and
to create space for productive and social investment. Revenue mobilization
and current expenditure rationalization should be key elements of
the adjustment effort. In particular, Directors underscored the
importance of streamlining tax exemptions, broadening the income
and value added tax base, simplifying the value added tax, and strengthening
tax administration. In this regard, Directors welcomed the downward
revision of the fiscal deficit target for 2007 stemming from an
increase in tax revenue, elimination of fuel subsidies, and containment
of the wage bill. They called for a sharper fiscal adjustment than
envisaged in the 2008 budget proposal, to ensure that the 2008 budget
deficit target is consistent with the medium-term fiscal consolidation
plan.
Directors noted the significant risk of public debt distress in
Sri Lanka, arising from heavy reliance on dollar-denominated, short-term
commercial debt. They stressed the need to lengthen and smoothen
the maturity profile of the debt to reduce rollover and liquidity
risks, including through capital market refinancing, and to improve
debt management in general.
Directors were concerned that the decision to deviate from the automatic
pricing formula for diesel and kerosene in 2008 could expose the
budget to large fiscal and quasi-fiscal risks, if international
oil prices remain high or continue to rise. They called for full
or significant pass-through of international oil price movements
to contain these risks and to promote energy conservation.
Directors considered that further monetary tightening in the near
term is warranted in view of the current fiscal risks, strong growth
of credit, and inflationary pressures. They advised that open market
operations be stepped up and that treasury security rates be allowed
to adjust to levels that would help bring down inflation to single
digit levels. Policy rates should also be adjusted gradually to
align them with market interest rates, thereby restoring their signaling
role in the conduct of monetary policy. Directors also encouraged
the authorities to improve the coordination of fiscal and monetary
policies.
Most Directors agreed that the real effective exchange rate remains
broadly in line with economic fundamentals, given the recent trade
performance. Directors underscored that greater flexibility of the
exchange rate will be needed to reduce external vulnerabilities
and safeguard official reserves. In this regard, they welcomed the
authorities’ commitment to let the exchange rate be market
determined, and called for continued attention to the exchange rate
in light of potential external pressures arising from high oil prices
and the emerging debt refinancing burden.
They
recommended that intervention in the foreign exchange market be
limited to smoothing excessive volatility of the exchange rate,
while allowing for a build-up of foreign reserves to more comfortable
levels. The authorities were urged to eliminate the exchange restriction
arising from the remaining import margin requirement on motor vehicles
expeditiously.
Directors commended the progress in strengthening prudential regulations,
enhancing banking and insurance supervision and central bank operations,
and improving financial market infrastructure. They encouraged continued
financial sector reform, guided by the Financial Sector Assessment
Program (FSAP) update, with particular emphasis on further improving
banking sector resilience, strengthening risk-based supervision,
advancing the preparatory work for Basel II adoption in 2008, and
accelerating the operational restructuring of state-owned banks.
Directors also urged the authorities to limit state interference
in the operations of state-owned banks, and some Directors renewed
the call for privatization of these banks.
Directors welcomed the launch of the authorities’ broad-based
Ten-Year Horizon Development Plan (2006-2016), which includes a
comprehensive growth and poverty reduction strategy. They underlined
the importance of building consensus on the targeted mix of policies
and reforms. Regarding the energy sector restructuring plan, Directors
welcomed the emphasis on reducing energy costs. However, they called
for timely measures to address the current financial imbalances
in the Ceylon Electricity Board, including adjustment of electricity
tariffs to cost-recovery levels accompanied by adoption of an appropriate
safety net to protect the poor.
Directors welcomed the launch of the authorities’ broad-based
Ten-Year Horizon Development Plan (2006-2016), which includes a
comprehensive growth and poverty reduction strategy. They underlined
the importance of building consensus on the targeted mix of policies
and reforms. Directors noted the significant risk of public debt
distress in Sri Lanka, arising from heavy reliance on dollar-denominated,
short-term commercial debt.
Directors urged the authorities to tighten macroeconomic policies,
while acknowledging that a return to political stability will also
be crucial in underpinning sustained economic progress going forward.
The
Good, Bad and the Ugly
Executive
Directors welcomed Sri Lanka’s impressive recent growth performance,
which has led to a sharp reduction in unemployment and rising per
capita income.
Growth has been underpinned in part by expansionary fiscal and monetary
policies, leading to an increase in macroeconomic and external sector
vulnerabilities. In particular, inflation has accelerated, the external
current account deficit remains large, and gross official reserves
are relatively low.
Directors called for a determined effort to reduce the fiscal deficit
to 5 percent of GDP by 2010-11 as planned. This will be essential
to ensure public debt sustainability and to create space for productive
and social investment.
Directors were concerned that the decision to deviate from the automatic
pricing formula for diesel and kerosene in 2008 could expose the
budget to large fiscal and quasi-fiscal risks, if international
oil prices remain high or continue to rise.
They
called for full or significant pass-through of international oil
price movements to contain these risks and to promote energy conservation.
Directors considered that further monetary tightening in the near
term is warranted in view of the current fiscal risks, strong growth
of credit, and inflationary pressures.
Directors also encouraged the authorities to improve the coordination
of fiscal and monetary policies.
The real effective exchange rate remains broadly in line with economic
fundamentals, given the recent trade performance. Directors underscored
that greater flexibility of the exchange rate will be needed to
reduce external vulnerabilities and safeguard official reserves.
Directors commended the progress in strengthening prudential regulations,
enhancing banking and insurance supervision and central bank operations,
and improving financial market infrastructure.
|
